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The SEC: Outmanned, Outgunned, and On a Roll

One late afternoon in March 2007, Sanjay Wadhwa sat at his desk transfixed by the data on his computer screen. Wadhwa was then a low-level supervisor in the Wall Street office of the U.S. Securities and Exchange Commission investigating a supposedly routine case of “cherry-picking.” The SEC had gotten a complaint that Rengan Rajaratnam, the founder of Sedna Capital Management, a small hedge fund, was doling out a disproportionate share of his best trades to the beneficiaries of a “friends and family” account. It was Wadhwa’s job to figure out what was going on.

The day was winding down, and Wadhwa could have used an evening run. It’s not strange for an employee of the SEC to leave the office at 5:30 p.m. on the dot—the National Treasury Employees Union, which represents the agency’s non-managerial workers, basically encourages it—but Wadhwa stayed at his desk, considering the data. Rengan Rajaratnam was trading technology company stocks, and he routinely did so just before an earnings announcement jolted their prices. Wadhwa also noted that one of Sedna Capital’s lucky insiders happened to be the fund manager’s older brother, Raj Rajaratnam, co-founder of the Galleon Group. The elder Rajaratnam was a hedge fund industry star who had became a billionaire through his ability to “arbitrage reality,” as he not-so-modestly put it. He owned homes in Manhattan, Connecticut, and Miami, and kept a private jet at a small airport near New York to ferry clients to the Super Bowl and Las Vegas.

With the trading records of both brothers side by side on his computer, Wadhwa noticed that Raj and Rengan somehow managed to buy and sell shares with the same fortuitous timing. He called in two other staff attorneys and pointed to the screen. “I think Raj is our guy. If anybody is getting inside information, it’s him. His Rolodex would be bigger and fatter than Rengan’s.”

Wadhwa was right. The investigation would explode into what federal prosecutors have called the biggest insider trading case in history. It also ushered in a new era at the SEC, which has been on a four-year transformation. The SEC filed 735 enforcement actions in 2011, a record for the agency. It collected $928 million in penalties, almost four times the amount it collected in 2008. Rajaratnam is in jail—though he is appealing—and his case has generated scads of leads, which the SEC continues to pursue. On May 21 a fish even larger than Rajaratnam will appear in court: Rajat Gupta, the senior partner of McKinsey. Gupta, a former director on the board of Goldman Sachs (GS), stands accused by the SEC and the Department of Justice of tipping Raj Rajaratnam about the bank’s inner workings as the financial markets fell apart in 2008. Gupta has pleaded not guilty.

The SEC has also settled lawsuits against J.P. Morgan Securities (JPM), Wachovia Capital Markets, and Goldman Sachs for misleading investors in securitized debt packages, such as collateralized debt obligations, during the financial crisis. It has been particularly attentive to Goldman Sachs. The SEC extracted a record $550 million settlement from the bank two years ago in a case involving a claim that the Wall Street firm had misled investors in a CDO on the eve of the financial crisis. According to the SEC lawsuit, the bank had allowed hedge fund manager John Paulson, who shorted the CDO and who was not charged, to select the troubled subprime mortgages that would determine its performance. In these cases the settlements did not include an admission of guilt.

In April, Goldman agreed to pay $22 million to resolve SEC claims that it allowed researchers to hold weekly “huddling” session where they shared nonpublic information with top clients. (Goldman admitted to some of the SEC’s fact findings, and neither admitted nor denied the remainder.) The firm also recently disclosed that it has been warned by the SEC that it might be sued again for possible misdeeds involving the sale of mortgage-backed securities. Goldman Sachs declined to comment.

The SEC has created a special asset management unit to pursue hedge funds. It revealed in December that it had used a statistical analysis to take action against individuals involved in four funds whom it accused of beautifying results, among other things. This is refreshing for an agency that failed to detect hedge fund manager Bernie Madoff’s $65 billion Ponzi scheme despite repeated warnings from money manager Harry Markopolos. In a U.S. Senate hearing after Madoff’s December 2008 arrest, Markopolos said, “The typical SEC staff attorney would have trouble finding ice cream in a Dairy Queen.”

The SEC has made progress despite every disadvantage. In traditional law enforcement, a policeman does not have to be particularly smart to outsmart a criminal. SEC agents, without criminal justice powers or huge salaries, are expected to police the brightest minds out of the best colleges.

Yet competing for talent with the cash and freedom offered by the private sector is not the SEC’s largest problem. Often it’s the government itself. If the SEC was “asleep at the switch” during the boom, as is often said, it’s fair to say it was drugged. A 2009 report by the U.S. Government Accountability Office found that under former Chairman Christopher Cox, who served from 2005 to 2009, management at the SEC actively discouraged enforcement attorneys from bringing cases. Despite the rampaging markets, the agency assessed just $256 million in penalties in 2008. “Under Cox, the commission put all kinds of restrictions on enforcement,” says William Black, a former litigation director for the Federal Home Loan Bank Board who now teaches economics and law at the University of Missouri at Kansas City. “Their efforts were designed to throw sand in the gasoline tank, and it worked.” Cox declined to comment.

Politics make the SEC’s job difficult in every administration. In March, Chairman Mary Schapiro, appointed by President Barack Obama in 2009, appeared before the House Subcommittee on Financial Services and General Government to argue for a $1.5 billion budget, an 18 percent increase. That’s roughly what Wells Fargo (WFC) spent last year on outside data processing and telecommunications. “It just worries me that in spite of all the money we threw into the SEC, y’all still missed Madoff,” said Representative Jo Ann Emerson (R-Mo.). The SEC receives no taxpayer dollars; it is entirely funded by fees Congress allows it to collect on securities transactions, which equal 2 on every $1,000 of trades. And that budget is only partially directed to enforcement; the majority, more than two-thirds, goes to its more prosaic duties, such as conveying data to investors and crafting policy.

Photograph by Thomas PriorSEC Enforcement Director Robert Khuzami on the roof of SEC headquartersYet despite every obstacle the SEC has had a string of successes, including the Galleon investigation, which has yielded 56 arrests and 48 convictions. Raj Rajaratnam was sentenced to 11 years in prison last October after an eight-week trial. (He has appealed his conviction.) “The thing about the SEC and Sanjay Wadhwa is they were present and watchful at the very start of the Galleon case,” says Preet Bharara, the U.S. Attorney for the Southern District of New York, who makes the big announcements about criminal arrests even on cases originated by the paper shufflers at the SEC. “It would be hard to overstate their importance,” says Bharara.

The twists and turns of the Galleon probe—revealed here for the first time through the eyes of the SEC and the lawyer who broke the case—reveal much about the SEC’s challenges: its complacent culture, its Byzantine bureaucracy, and its statutory weaknesses. They also show how the SEC overcomes those challenges. “We don’t have handcuffs,” says Wadhwa. “All we have are our pencils, our rulers, and our calculators.”

Wadhwa’s office in the World Financial Center in lower Manhattan isn’t really an office. There are no flourishes of personality or decorations of any kind. The walls are a drab yellow; the carpet is mustard-colored. It’s a room cluttered with stacks of documents, which crowd the desk, window sill, and floor. Even now, months after Rajaratnam went to jail, most of them are from the Galleon case and its related investigations.

Wadhwa is 45 and looks a decade younger. Born in New Delhi, he came to the U.S. with his parents and two sisters when he was 19. He got an undergraduate degree in accounting from Florida Atlantic University and a law degree from South Texas College of Law. He added a master’s in tax law from New York University in 1996 and spent the next seven years working in private practice, first at Cahill Gordon & Reindel and then at Skadden, Arps, Slate, Meagher & Flom. Among other things, he helped Wall Street clients construct some of the derivatives that would become infamous during the financial crisis.

Toward the end of his private-sector stint, Wadhwa says he felt burned out. In 2003 he applied for a job in the New York office of the SEC’s enforcement division. Mark Schonfeld, then head of the New York office and now a partner at Gibson, Dunn & Crutcher, was puzzled by Wadhwa’s r sum : “He’d never been a litigator,” Schonfeld recalls. “I wondered, ‘Is this something he really wants to do?’ ” Still, he hired Wadhwa as an entry-level staff attorney at half his private-sector salary. In a way, it was a no-lose deal for Wadhwa: A lot of people do a few years at the SEC and leave for high-paying jobs at large firms.

The SEC was quite different from the big firms he had worked at. Wadhwa thought nothing of putting in long hours at Skadden Arps. The firm gave him a BlackBerry so he would always be on call, and there were paralegals to make copies and such. When he arrived at the SEC, only the managers got smartphones, and he wasn’t a manager. Staff attorneys went home at 5:30 p.m. If they stayed an extra hour each night, they could take every other Friday off. Many did. Wadhwa made his own copies and sent his own faxes.

These drab chips of office culture were only the tip of an unfathomable bureaucratic iceberg. Even before Cox became chairman and added additional layers of sign-offs to an already burdensome process, it could take weeks to get a decision on an investigative matter. If Wadhwa needed the authority to issue subpoenas in a case, he had to write a memo requesting a “formal order of investigation.” It would then be reviewed by four levels of management in the New York office before it was forwarded to Washington for final approval by the agency’s five commissioners. “Painful,” he says.

Yet for someone of Wadhwa’s thorough disposition, the job had its rewards. On his first day, his supervisor led him into a windowless room in which there were 70 boxes of trading records, e-mails, and offering memorandums subpoenaed in an insider trading investigation involving a new Wall Street fad: private shares in public companies. “Here’s your first project,” his boss said. “Go through the documents. See what you can find.”

With his law firm experience, Wadhwa was able to make sense of the paperwork. He used the contents of the boxes to figure out that certain participants made bets against the public shares of the companies knowing they would decline after the issuing of private stock was announced. The SEC turned his findings over to the U.S. Attorney. In 2005, Guillaume Pollet, a managing director at S.G. Cowen, pleaded guilty to insider trading charges. Shortly after, Wadhwa was promoted to a supervisory position. One of the rewards was a BlackBerry.

By 2007, Wadhwa and some of his colleagues had figured out the SEC’s only advantage: immutability. Unlike the firms and people it regulates, the federal government isn’t going anywhere fast. So it might as well go slow. As an investigatory method, this translates into the staff collecting as much information as possible—phone records, trading records, lists of people at public companies who possessed confidential information—and sequestering themselves until they can figure out if they have anything.

Fast-moving Galleon walked right into Wadhwa’s trap. In 2006, Galleon registered with the SEC as a “regulated investment adviser,” which meant it was required to preserve all electronic correspondence. Thus, in response to an SEC subpoena in May 2007, it was compelled to turn over 4 million pages of documents, several hundred thousand e-mails, and 50,000 instant messages. It was far too big a payload for Wadhwa and his colleagues to sort by themselves, so the agency’s examination team pitched in.

After Wadhwa’s discovery of synchronized trading between the Rajaratnam brothers—Rengan was never charged—the SEC subpoenaed Raj Rajaratnam. On June 7, 2007, the portly fund manager arrived at the reception area of the SEC’s office to testify. Wadhwa led his guest into a conference room with the same dispiriting color scheme as his office. Flanked by two lawyers, Rajaratnam spent the entire day fielding questions as if there were nothing he cared about more than helping the agency investigate his firm. He denied that he was trading stocks illegally. He insisted there was no need; Galleon had a deep research bench. “I have 34 analysts,” said Rajaratnam. “It costs me something like 30 or 60 million to keep them happy.” He joked about Paris Hilton’s recent DWI arrest.

At one point, Wadhwa’s BlackBerry buzzed. It was an e-mail from a member of the exam staff who had found a string of instant messages between Rajaratnam and someone called Roomy81. Andrew Michaelson, a young staff attorney, was doing the questioning. In a break, Wadhwa pulled him aside. They didn’t want to let on that this was something more than a routine proceeding, but they decided it couldn’t hurt to ask who this person was. When Rajaratnam resumed his testimony, Michaelson inquired nonchalantly, “Are you familiar with a Roomy81 instant message address?”

“Yes,” Rajaratnam replied. He said her name was Roomy Khan.

“Who is that?”

“She worked at Galleon,” he said. “Then she left Galleon to start her own fund. I think she primarily manages her own money.”

Four days later the SEC found an instant message from Khan to Rajaratnam in which she appeared to be providing inside information about the telecommunications company Polycom (PLCM): She told him not to buy the stock until she got earnings guidance. The investigators looked at their trading records. It was just as they suspected. Khan called the hedge fund manager several times before earnings announcements by Polycom; they both traded the stock.

After these discoveries, Wadhwa started to become more secretive. He and his team members talked about their cases in code when they went down to the food court. Wadhwa was known to shush other SEC employees if they talked business on the elevators.

Other SEC workers were curious. “They knew something was going on, but that was it,” Wadhwa says. “They would ask, ‘What are you working on?’ We would say, ‘Oh, this and that.’ ” Unlike many SEC employees, Wadhwa and his team often worked nights and weekends. Periodically, one would burst into another team member’s office to announce a discovery—they discovered, for example, that Rajaratnam was frequently in contact with Rajiv Goel, a managing director at Intel (INTC) and one of his former classmates at the University of Pennsylvania’s Wharton School. Rajaratnam traded in and out of Intel on a daily basis, but just because Galleon’s co-founder was on the phone with his college chum didn’t prove anything. Finally, Jason Friedman, another young lawyer on Wadhwa’s staff, figured out that someone was logging into Goel’s Charles Schwab (SCHW) account via a computer at Galleon and making trades (using inside information, of course) on his behalf. It was clearly a quid pro quo. Friedman couldn’t help it; he ran across the hall to tell his boss. Goel later pleaded guilty.

In September 2007, Wadhwa and his group met with representatives of the U.S. Attorney’s office and the FBI. The Galleon case was entering a new phase and Wadhwa suggested the FBI approach Khan about cooperating. The SEC typically lays the groundwork for the Department of Justice in criminal cases involving Wall Street. If the U.S. Attorney’s office brings a successful criminal prosecution, it’s all but assured that the SEC will be able to extract civil penalties from the same individuals, but the prosecutors tend to get all the credit because they put people behind bars. Thus, Bharara ends up on the cover of Time under the headline, “This Man Is Busting Wall St.” By the time the civil case is wrapped up, the press is tired.

The FBI warmed to Wadhwa’s suggestion. As it turned out, Khan had been captured on videotape faxing internal information to Rajaratnam when she was an employee at Intel. She cooperated with an investigation. No charges were filed against Rajaratnam. Khan pleaded guilty in 2001 to wire fraud charges.

A month later, FBI Special Agent B.J. Kang, a square-jawed Taiwanese immigrant who wore government-issued windbreakers, knocked on the door of Khan’s home in northern California. “I have to co operate,” she sobbed to him. “Otherwise, I’ll go to jail.” Kang called Wadhwa with the news: Khan had flipped.

In 2008, SEC attorneys sat in on several meetings with Khan in New York at the U.S. Attorney’s office. A heavyset woman with dark eyes, Khan promised to provide incriminating information about her trading partners in hopes of getting a lesser sentence. This did not necessarily mean she was forthright. She told her inquisitors that she bought Hilton Hotels stock on the eve of the company’s acquisition by the Blackstone Group (BX) in 2007 because she thought Paris Hilton’s DWI bust around the same time would be good publicity for the company. The SEC said her phone records told a different story. This sharpened Khan’s memory. She admitted she had been tipped by Deep Shah, a Moody’s Investors Service (MCO) analyst, who was evaluating the hotel company’s debt before the deal went through.

The U.S. Attorney’s office wanted Khan to record her conversations with Rajaratnam to catch him in what she referred to as a “dirty call.” She agreed. According to a transcript of one of their conversations, he spoke about several stocks, including Intel.

“Are you hearing anything about Intel?” Khan asked him on Jan. 14, 2008.

“Intel, I think, will beat the current estimates by like, 9 to 10 percent and then guide down 8 percent,” Rajaratnam said.

It was enough for U.S. District Court Judge Gerald Lynch to grant a March 7, 2008, request by the U.S. Attorney’s office and the FBI to put a wiretap on Rajaratnam’s cell phone. Soon they were listening to the billionaire trade information with characters including Goel, Anil Kumar, a McKinsey consultant who fed Rajaratnam information about clients such as Advanced Micro Devices (AMD), and Rajat Gupta, a Goldman Sachs board member who allegedly tipped the Galleon co-founder about Warren Buffett’s investment in the bank in September 2008.

Under federal law, the SEC isn’t permitted to listen to live wiretaps. “I don’t mean this in a dismissive way,” Wadhwa says. “But the U.S. Fish and Wildlife Service has access to wiretaps, but the SEC doesn’t? And somehow you expect us to oversee Wall Street? There has to be some relationship between the responsibilities and the tools.”

Wadhwa and his team members continued building their civil case against Rajaratnam and assisting federal prosecutors as best they could. From time to time, Wadhwa would get a call from an FBI agent who couldn’t understand something in the case. The agent would ask questions in hypothetical terms to avoid revealing his source. Wadhwa assumed this meant criminal prosecutors were using wiretaps in the Galleon case. The FBI wasn’t even permitted to tell him whether there was a tap.

By summer 2008, as the economy was collapsing and an election was approaching, Wadhwa began to feel pressure to file his case from his superiors in Washington, who worked under the SEC’s former enforcement director, Linda Chatman Thomsen. It didn’t matter that the U.S. Attorney’s office was in the middle of its investigation. As far as his superiors were concerned, Wadhwa and his team had enough to satisfy the lower burden of proof in a civil trial.

Wadhwa resisted. He told his bosses he had discovered more suspects who were trading on the same information as Khan and Rajaratnam. Eventually, they would lead the U.S. Attorney’s office and the SEC to Primary Global Research, a Silicon Valley firm whose employees connected hedge funds with people at companies such as Dell (DELL) and AMD. Wadhwa could feel his investigation moving in a promising new direction. “We wanted to bring these faces into focus and see what role they were playing,” he says. He feared that if he moved too quickly against Rajaratnam, these new suspects would destroy evidence that the SEC and the U.S. Attorney’s office needed to take them down.

The pressure eased after Schapiro was appointed to head the SEC in January 2009. A soft-spoken career regulator, Schapiro had served as an SEC commissioner before. She became the face of the SEC on Capitol Hill, advocating for more funding and more regulatory authority under Dodd-Frank. She also made it clear that she wanted a tougher agency. To head the enforcement division, she picked Robert Khuzami, a former prosecutor who had jailed white-collar criminals and terrorists in the U.S. Attorney’s office in the Southern District of New York before departing in 2002 to become an attorney at Deutsche Bank (DB).

Shortly after Khuzami arrived, he reviewed the Galleon case. In a telephone conversation, Wadhwa nervously gave his new boss an update. He was relieved when the enforcement director told him to take his time. “I just trusted Sanjay,” Khuzami recalls. “He didn’t need me micromanaging and second-guessing him.”

That gave Wadhwa a short reprieve. On Oct. 15, 2009, the FBI overheard the Galleon co-founder making plans to fly to London to attend a movie premiere. Fearing that Rajaratnam might flee the country, the bureau decided to arrest him. Wadhwa received a heads-up and stayed in the office all night preparing the SEC’s civil suit against the hedge fund manager. The next morning, at 7 a.m., the U.S. Attorney’s office e-mailed him the criminal complaint containing excerpts from the wiretaps. It was the first time he knew for sure of their existence. Wadhwa is convinced that if Rajaratnam had been picked up any sooner, many of the figures involved with Primary Global Research would never have been caught. “There is no doubt in my mind,” he says.

As far as Wadhwa was concerned, Schapiro and Khuzami were just what the SEC needed. Says Schapiro: “I wanted everyone to have a sense of urgency. I wanted people to act like their hair was on fire.” Khuzami conducted the biggest overhaul of the enforcement division since its creation in the 1970s. One of the first steps was to eliminate the requirement that the enforcement staff get approval from the agency’s five commissioners before issuing subpoenas. Khuzami says this was an “empowering event” for his staff. “Now if I’m doing a parallel case with some criminal prosecutor and he issues a subpoena in 30 minutes, I can do the same thing,” he says. “I don’t have to say, ‘Oh, excuse me, can you wait 10 weeks while I create my memo and get it approved?’”

Previously, the division’s attorneys had often been generalists who flitted from case to case. Khuzami shifted 20 percent of his 1,200-person staff into specialized units focusing on areas such as insider trading, structured finance abuses, and municipal bond scams. As a result the SEC has filed bigger and more sophisticated cases.

Which is not to say that Khuzami’s tenure has been trouble-free. In November, U.S. District Court Judge Jed Rakoff admonished the SEC for not being tough enough on Citigroup, refusing to sign off on the SEC’s $285 million settlement negotiated with the bank. Rakoff’s objection: The agreement included one of the SEC’s standard clauses allowing the defendant to “neither admit nor deny” wrongdoing. Khuzami responds that the SEC wouldn’t have gotten a substantially larger amount if it had taken the case to trial. The agency has appealed the decision. It was the first time since 1984 that the agency has challenged a judge’s decision in an enforcement case. (In March the appellate court indicated it was likely to rule in the SEC’s favor.)

“The problem with enforcement divisions in the past has been that the industry has always stayed at least one step ahead of them,” says former SEC Chairman Arthur Levitt (who is also a director of Bloomberg LP). “In recent years it has been two and three steps ahead. [Khuzami] has diminished the gap between regulator and regulated from a chasm to just a normal-sized gap.”

Wadhwa was once again at his document-strewn desk on Feb. 10, 2012, when his phone rang. It was Marc Berger, then deputy chief of the U.S. Attorney’s securities fraud unit in Manhattan. He wanted Wadhwa to know that the FBI had arrested Douglas Whitman, a hedge fund manager in Menlo Park, Calif. This wasn’t surprising. Wadhwa had a complaint ready charging Whitman with insider trading. He handed it to an SEC paralegal and told him to head to the courthouse.

Whitman was a familiar figure to Wadhwa. He had discovered the hedge fund manager five years ago while looking at Khan’s phone records. He was one of her neighbors in California. The SEC alleges that she shared the same tips about Google’s (GOOG) earnings with Whitman in 2007 that she provided to Rajaratnam. According to the complaint, Whitman made $620,000 on the stock and then sent Khan flowers.

A week after Whitman was busted, the U.S. Attorney and the SEC filed charges against John Kinnucan, another suspect in the expert network case. Kinnucan gained notoriety in 2010 when he refused to cooperate after FBI agents visited his Portland (Ore.) home as he was enjoying a late afternoon glass of wine. He has pleaded not guilty. “This is all ultimately growing out of the Galleon investigation,” said Wadhwa later that day. “That’s really where the seeds were planted that led to this expert networks investigation. Frankly, that’s going to be larger than the Galleon investigation.”

Wadhwa is now deputy chief of the SEC’s market abuse group, which handles insider trading, among other things. He has 55 people reporting to him and is trying to teach them what he has learned. The Galleon case continues. Shortly after Rajaratnam’s arrest, the U.S. Attorney’s office turned the recordings of the Galleon wiretaps over to Rajaratnam. Although Rajaratnam’s defense team had them, the SEC still did not. After more than a year of legal tussling, the SEC finally got them in February 2011 through the discovery process in the civil suit. Wadhwa has several staff attorneys listening full-time to the 16,000 intercepted calls. The SEC has yet to file a case as a result. Wadhwa believes it is only a matter of time. “I have faith,” he says. “I personally don’t think we got all of Raj’s insider trading,” Wadhwa adds. “It would be foolhardy to think so.”